Tax reform uncertainty testing alternative investors

Proposals could have big impact, but how it plays out is unclear

Bill Sacher
Bill Sacher said many of the ideas espoused by candidate Donald Trump are now getting little attention.

Congressional Republican tax proposals dating from before the 2016 election and ideas that President Donald Trump has espoused since taking office that could alter the alternative investing playbook and push down returns are sparking a lot of potential investment scenarios but no real answers.

The unsettled nature of tax reform is causing a great deal of uncertainty in the private equity and real estate investment industries. Increasing the uncertainty, on April 12, President Trump said he now plans to finish health-care reform before he tackles tax reform.

Even so, investment managers are debating scenarios which, if they come to fruition, would be a test for them, insiders say.

Proposals that include a border tax, elimination of the interest deduction on corporate debt and a change in the tax treatment of capital expenditures have gotten “very little attention,” said Bill Sacher, partner and head of private credit in the New York office of alternative investment fund-of-funds and secondary market manager Adams Street Partners LLC.

“If all of this came to fruition as proposed, which is probably not that likely, I think it would make certain kinds of companies more valuable than other kinds of companies,” he said.

Slicing into returns

For example, removing interest rate deductibility of portfolio companies would slice private equity returns, he said. Companies now can deduct interest expense from their taxable earnings. Congressional Republicans are proposing to eliminate the interest deduction. “Interest deductions in leveraged buyouts are a pretty consequential part of the economics of the deal,” Mr. Sacher said.

Should interest on business loans no longer be deductible then the value of portfolio companies will drop, because potential buyers will expect to pay less for the companies, said John Toomey, a managing director at private equity fund-of-funds manager HarbourVest Partners, LLC, Boston.

Private equity funds' investors would be hurt because the value of their investments would suffer, he said.

A border tax on imports would affect already-battered retailers and other companies that import goods, making them less valuable investments. What's more, should Congress eliminate companies' ability to amortize capital expenditures, it would materially reduce the valuations of most service companies.

The American Investment Council, a Washington-based private equity industry trade group, is keeping tabs on the developments, said spokeswoman Laura Christof. It is unclear when, or if, Congress will enact tax reform, but the American Investment Council is using the House Republican blueprint, issued June 24, as a reform guide.

“The proposal within this blueprint to eliminate full interest deductibility in favor of 100% expensing would not only damage the (private equity) industry, but all industries that use debt financing,” Ms. Christof said in an email. “This is a critical issue for us and for the health of the economy.”

The American Investment Council is also concerned with the taxation and treatment of carried interest capital gains and pass-through entities, Ms. Christof noted. “We have strong support from both House and Senate Republicans on these two issues,” she said.

Still, most industry insiders say the one thing that's certain is the uncertainty surrounding tax reform. “I'm not even close to calling this,” said Adams Street's Mr. Sacher. “How this all plays out is uncertain, and uncertainty is not a great thing for investors.”

Even though the negative impact of any tax reform proposal could be at least partially offset if Congress also lowers the corporate tax rate, the uncertainty is one reason Adams Street executives are playing it safe. “For lenders, we have a bias toward safer senior secured loans until all of this gets sorted out,” Mr. Sacher said.

While the effect of tax reform is hard to predict, manager optimism on an eventual easing of regulations is being built into deals, boosting prices, said Thierry Adant, investment consultant in the New York office of consulting firm Willis Towers Watson PLC. “People think that something will happen,” Mr. Adant said.

Everyone is asking questions about tax reform as well as the possible elimination of regulations required by the Dodd-Frank Wall Street Reform and Consumer Protection Act but no one is answering them, said Daniel Martin, partner focused on real estate in the New York office of law firm McDermott, Will & Emory.

For real estate, changes could make certain companies less valuable as tenants. Some proposals could make it harder to refinance mortgages and commercial mortgage-backed securities coming due. And elimination of post-global financial crisis regulations, including those regulating securitization of real estate loans, would make them less safe, he said.

“Financial regulations and stricter lending control actually worked,” Mr. Martin said. Mortgages and pools of those mortgages issued after the crisis have more stringent underwriting standards, he said. “The loans are better loans on more conservative terms on better properties” than before the financial crisis, he said.

Betting on a milder version

Some managers are betting Congress will eventually pass a milder version of the Republican blueprint. Elimination of the “deductibility of interest will be a difficult thing to get done,” said Theodore L. Koenig, president and chief executive officer of Chicago-based middle-market private debt manager Monroe Capital LLC. “It sounds interesting to talk about, but the lobbies in the private equity and the real estate industries are the strongest of them all. Eliminating interest deductibility will be almost impossible to get approved.”

Other managers are pointing to statements made earlier this year that tax reform will be milder.

During a Blackstone Group earnings call with the media in January, Tony James, president and CEO, predicted the Republicans will have a hard time passing the reform measures listed in their blueprint. “The changes to the tax code being discussed, including border adjustability, lower corporate tax rates, non-deductibility of interest and expensing of capital expenditures would have far-ranging and complex effects,” Mr. James said.

Blackstone executives expect the New York-based alternatives investment firm to be one of the winners. “For investors that have locked-up capital, greater access to information and best-in-class talent, upheavals such as this usually represents a golden opportunity,” Mr. James told reporters.

When later asked how Blackstone's portfolio is positioned to withstand the upheaval that could be caused by tax reform, Mr. James acknowledged that was a “tough question.”

“And while we have some winners and some losers on balance, you know the benefits of expensing capital expenditures and lower tax rates offset the loss of deductibility interest. And then as regards border adjustability, it depends on what you believe about currencies and which companies import and which companies export,” he said. “But as you play that through on a dynamic basis, again we think we'll be fine.”

This article originally appeared in the April 17, 2017 print issue as, "Tax reform uncertainty testing investors".